Insights

We have all heard about the change in the tax law for 2010 that now allows individuals with annual income levels above $100,000 to do a Roth IRA conversion. In previous articles, we have written about reasons an individual should consider converting their traditional IRA to a Roth IRA. This article is a bit different; it addresses the business owner that has a net operating loss (NOL). The elimination of adjusted gross income (AGI) limits creates an opportunity for a business owner with NOL and a traditional IRA to convert to a Roth IRA without generating additional tax consequences.

When a business owner has a NOL, itemized deductions and personal exemptions often go unused. Normally, your options are: (1) Apply the loss to a previous tax year (carryback); (2) Offset the loss with current year regular income; or (3) Carry the loss forward and apply it to a future tax year. When you convert a traditional IRA to a Roth IRA, the amount that is converted is considered ordinary income. Using option (2) or (3), current or carryforward losses may be used to offset a conversion. There is no additional tax liability to the business owner to the extent that the NOL exceeds the income generated from the IRA conversion. If NOL does not exceed current income, you can use personal itemized deductions against any remaining income. Lastly, there is no limit to the amount of ordinary income that can be offset by NOL (unlike the $3,000 limit on a capital loss carryover).

Let’s look at an example:

Let’s say a sole proprietor who is married has a traditional IRA worth $200,000. His wife earns $70,000 annually. They also have income from dividends and interest totaling $10,000. Their non-business deductions total $35,000 (itemized deductions – excluding charitable deductions and personal exemptions). He has business losses that total $200,000. How much can the business owner convert without incurring any additional tax? He may convert $120,000. The calculation follows:

Example is for illustrative purposes only.

The result is the movement of a traditional tax-deferred retirement asset to a tax-free Roth IRA account at a zero tax rate.

These calculations can be complex, and investors should consult with a tax professional or financial advisor to determine the best strategy for reporting a loss relating to their particular situation.

Schneider Downs provides accounting, tax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA, and Columbus, OH. 

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

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